In: Finance
The three methods of managing risk are: Loss control Loss financing Internal risk reduction Discuss these, making specific reference to how they apply to the role of a treasury risk manager
Risk management methods:
These methods are not mutually exclusive and may be largely categorized as:
Usually, loss control and internal risk reduction include the decisions to invest (or forgo investing) resources to cut down the expected losses. These are theoretically similar to other investment decisions, such as a company’s decision to purchase a new plant or an individual deciding to buy a computer. Loss financing decisions are the decisions concerned about the manner of paying for the losses if they do occur.
Loss control
The activities which decrease the expected cost of losses by lowering the occurrence of losses and/or their extent are referred as loss control. Sometimes loss control is also termed as risk control. Usually, the actions basically affecting the frequency of losses are referred as loss prevention methods. Actions primarily influencing the severity of losses that do occur are often called loss reduction methods. An example of loss prevention would be routine inspection of aircraft for mechanical problems. These inspections help reduce the frequency of crashes; they have little impact on the magnitude of losses for crashes that occur. An example of loss reduction is the installation of heat- or smoke-activated sprinkler systems that are designed to minimize fire damage in the event of a fire. The treasurer should be concerned with the monitoring and control of all treasury activities. He should therefore review all deals conducted, breached credit limits and any non-standard trades on a daily basis to ensure that any control failures related to treasury are immediately dealt with.
Loss financing
Methods applied to obtain funds for paying for or offsetting losses that occur are termed as loss financing (sometimes called risk financing). There are four broad methods of financing losses:
These approaches are not mutually exclusive; that is, they are often used in combination. With retention, a business or individual retains the obligation to pay for a part or the entire loss incurred. For example, a trucking company might decide to retain the risk that cash flows will drop due to oil price increases.
When coupled with a formal plan to fund losses for medium-to-large businesses, retention is generally called self-insurance.
Treasury risk manager example: Surplus cash can be invested to earn interest, and the treasurer must be sure that those issuing or insuring securities are financially sound and credit-worthy. One way to do this is by checking an issuer's credit rating, which provides an independent assessment of the likelihood that a third -party will pay on time and in full as expected. The treasurer must also be confident that counter-parties to financial instruments used to manage risks (such as interest rate swaps) will perform as expected.
Internal risk reduction
In addition to loss financing methods that allow businesses and individuals to reduce risk by transferring it to another entity, businesses can reduce risk internally. There are two major forms of internal risk reduction:
Regarding the first of these, firms can reduce risk internally by diversifying their activities (i.e., not putting all of their eggs in one basket). Individuals also routinely diversify risk by investing their savings in many different stocks. The ability of shareholders to reduce risk through portfolio diversification is an important factor affecting insurance and hedging decisions of firms.
The second major method of reducing risk internally is to invest in information to obtain superior forecasts of expected losses. Investing in information can produce more accurate estimates or forecasts of future cash flows, thus reducing variability of cash flows around the predicted value.